Overhead 4 Introduction to Open Economy Macro

Page 1: Introduction to Open Economy

• Lukas Mayr presents the concepts regarding an open economy.

• Focuses on macroeconomic principles and frameworks regarding international interactions.

Page 2: National Income Identity and Trade Balance

• Closed Economy:

  • All output produced is consumed and invested domestically.

  • National accounting identity:

    • Equation: 𝑌 = 𝐶 + 𝐼 + 𝐺

      • Where:

        • 𝑌 = National output

        • 𝐶 = Consumption

        • 𝐼 = Investment

        • 𝐺 = Government spending

• Open Economy:

  • Introduces transactions with foreign economies:

    • Equation:

    • 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀

      • Where:

        • 𝑋 = Exports

        • 𝑀 = Imports

• Trade Balance:

  • Defined as net exports:

    • Equation: 𝑁𝑆 = 𝑋 − 𝑀

  • Scenarios:

    • Trade Surplus: 𝑁𝑆 > 0 (𝑋 > 𝑀)

      • Economy spends less than it produces.

    • Trade Deficit: 𝑁𝑆 < 0 (𝑋 < 𝑀)

      • Economy spends more than it produces.

  • Domestic Spending vs. Output:

    • Equation: 𝑁𝑆 = 𝑌 − (𝐶 + 𝐼 + 𝐺)

    • Implies domestic spending greater than output leads to negative net exports.

Page 3: International Capital Flows

• Closed Economy Dynamics:

  • Savers lend to domestic borrowers only.

  • Investment financing limited to domestic resources.

    • Savings equals investment:

    • Equation: 𝑆 = 𝐼

• Open Economy Dynamics:

  • Savings can finance both domestic and foreign investment.

  • International Capital Flows:

    • Capital can flow abroad or return back to finance foreign assets.

  • Foreign Investment Types:

    • Financial Assets: Stocks, bonds.

    • Physical Assets: Ownership of factories, offices.

Page 4: International Capital Flows (Continued)

• Net Capital Outflow (NCO):

  • Equation: 𝑁𝐶𝑂 = 𝑆 − 𝐼

  • Scenarios:

    • If 𝑆 > 𝐼: Net lender (excess funds flow abroad).

    • If 𝑆 < 𝐼: Net borrower (firms borrow internationally).

• Linking Capital Outflow and Trade Balance:

  • Equation: 𝑌 − 𝐶 + 𝐺 = 𝑆 = 𝐼 + 𝑁𝑆

  • Therefore, 𝑆 − 𝐼 = 𝑁𝑆

  • Persistent trade deficits imply lower savings relative to investment (Example: U.S. is a net borrower).

Page 5: Saving-Investment Balance and Current Account

• Figure 1: Comparison of saving-investment balance and current accounts in China and the U.S.

• Trend analysis from 1995-2007 shows fluctuations in net savings and current accounts between two nations.

Page 6: The Balance of Payments

• Definition: Records all transactions between a country and the rest of the world.

• Components:

  • Current Account:

    • Records exports/imports of goods and services

      • Includes:

        • Net exports

        • Net factor payments

        • Transfer payments

  • Financial Account:

    • Records:

      • Purchases and sales of foreign/domestic assets

      • Transactions impact on financial flows.

Page 7: Balance of Payments Analytics

• UK Current Account Components Overview:

  • Graph depicting trends from 1987 to 2016 in the UK financial account elements.

• Key Components:

  • Direct Investment:

  • Trade:

  • Income:

  • Transfers:

  • Visual fluctuations highlight economic interactions over time.

Page 8: Nominal Exchange Rate

• Definition: Price of one currency in terms of another.

• Exchange Rate Methods:

  • Price of domestic currency in foreign currency.

  • Price of foreign currency in domestic currency.

  • Examples given for practical understanding.

Page 9: Nominal Exchange Rate Trends

• Graph showcasing fluctuations in nominal exchange rates from 2000 to 2016 across several currencies highlighting economic impacts during the period.

Page 10: Real Exchange Rate

• Definition: Relative price of domestic goods in terms of foreign goods.

• Equation for Real Exchange Rate (𝜖):

  • 𝜖 = 𝑒 𝑃 / 𝑃∗

• Variables:

  • 𝑒 = Nominal exchange rate

  • 𝑃 = Home price level

  • 𝑃∗ = Foreign price level.

Page 11: Law of One Price

• Assumptions: No transportation costs or trade barriers can lead to price equality.

• Concept: Same good in different countries must have the same price in a common currency.

• Arbitrage Opportunities: Price differences lead to profits as goods are sold from low to high-priced markets, correcting the price inequality.

Page 12: Law of One Price Contextualized

• International Context: Same good across countries must hold price equality when expressed in common currency.

• Purchasing Power Parity (PPP):

  • Equation: 𝑒 = 𝑃 / 𝑃∗

  • Ratio of price levels determines nominal exchange rates.

  • Potential for arbitrage remains unless equilibrium holds.

Page 13: Law of One Price Limitations

• Real World Limitations:

  • Not all goods can be traded.

  • Transportation costs affect pricing.

  • Goods from different markets can be imperfect substitutes.

Page 14: Trade Balance and Real Exchange Rate

• Referenced materials cover trade balance correlation with exchange rate variances.

• Covered and Uncovered Interest Parity: Further details discussed on projections.